Many leasing terms are confusing and terms are often used interchangeably. Leases viewed by the IRS for tax purposes may be treated differently by CPA's using FASB (Fair Accounting Standards Board) standards. For example a True Lease (IRS term) may not qualify as an Operating Lease (Accounting term), but an Operating Lease almost always qualifies as a true lease.

Below are some rules and guidelines regarding various types of leases. We strongly urge you to contact your professional advisors as to which type of lease is best for you.

Internal Revenue Service Classification

For IRS purposes, equipment leases generally fall into two categories, each with a different type of purchase option:

Non Tax-Oriented Leases: legal ownership resides with the Lessor, however because the Lessor is not considered to be at risk at the end of the lease because the Lessee has nominal (less than a fair market value) purchase option at the end of the lease, the Lessee receives the benefits of ownership.

Tax-Oriented True Leases: Lessor maintains ownership, fair market value purchase option at end of lease.

True Tax Lease Vs Non-Tax Lease

The true lease offers all of the primary benefits commonly attributed to leasing. It is a tax-oriented lease in which the Lessor claims the tax benefits of ownership through depreciation deductions, but passes through to the Lessee those benefits in the form of reduced rentals. The Lessor owns the leased equipment for the life of the contract.

The non-tax lease passes the tax benefits of ownership to the lessee. While the Lessor is legally the owner, the lessee may claim the depreciation and interest deductions. At the end of the lease term, the IRS believes that the Lessee would be compelled to exercise their purchase option.

When Does a Lease Not Qualify as a Tax Lease?

In order to avoid tax abuse the IRS issued Revenue Ruling 55-540 in 1955 which defined what was not a true lease for tax purposes, commonly referred to as a lease intended as a security. 55-540 holds a transaction not to be a true lease if any one or more of the following conditions are present:

1. Any portion of the periodic lease payment is applied to an equity position in the asset to be acquired by the lessee;
2. The lessee will automatically acquire title to the property upon payment of a specified amount of "rentals" he is required to make;
3. The total amount which a lessee is required to pay for a relatively short period of use constitutes an inordinately large proportion of the total sum required to be paid to secure the transfer of the title;
4. The agreed "rental" payments materially exceed the current fair rental value;
5. The property may be acquired for a nominal purchase option in relation to the value of the property at the time the option may be exercised; and
6. Some portion of the periodic payment is specifically designated as interest or its equivalent.

Accounting Classification

For a Lessee's book purposes, equipment leases also fall into two separate categories.

Operating Lease: the equipment acquisition is treated as a rental. Lease obligations are kept "off-balance sheet."

Capital Lease: the equipment acquisition is treated as a purchase and the asset is included on the balance sheet.

Accounting for Operating Lease Vs Capital Lease

In order to classify the lease as an operating lease, none of the four criteria set forth in FASB 13 for a capital lease can be present. These criteria are summarized as:

1. Title to the property automatically transferred to the lessee by or at the end of the lease term;
2. The lese contains a bargain purchase option;
3. The lease term is equal to or greater than 75% of the estimated economic life of the leased property;
4. The present value of the minimum lease payments at the beginning of the lease term is equal or greater than 90% of the fair market value of the property, reduced by any Investment Tax Credit retained and expected to be realized by the lessor (Prior to determining the 90% base).